Ask GFC 016 – We’ve Saved for Retirement – Now What?

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There’s a lot of talk on the web and in the financial media about how to prepare for retirement.

But there’s not nearly as much written or spoken about what you do with your money once retirement actually arrives.

Fortunately, we received an Ask GFC question from an unidentified reader on exactly that topic:

“Our retirement funds are invested by the labor unions we worked in, both traditional retirements and 401k’s. We are looking for the wisest things to do with these monies, i.e. pay off our primary residence mortgage, convert to Roths? We are both in our early 60’s. Can you help?”

This couple are in their early 60s, and there’s no indication if they are actually retired or just looking to align their finances in the best possible way for when they do. But whether they’re retired or very close to it, they’re asking excellent questions that a person who is either in retirement, or about to be retired, should be asking.

Let me start off by saying that there are no absolute answers here. Exactly what you will do with your money will depend on a number of variables that this reader has not included in his or her question. For that reason, I’ll try to answer each part of the question in the most general way possible. That will allow room for you to make adjustments based on your own personal circumstances.

There are two parts to this question – use the money to pay off the mortgage on the primary residence, or convert the money into a Roth IRA. (The question refers to “traditional retirements”, and I’m assuming that “traditional IRAs” is what was meant).

Let’s look at both options for your retirement savings.

Payoff Your Mortgage

I could more directly answer the reader’s question on this if more information was given on their specific circumstances. In fact, this is an excellent pre-retirement topic all by itself! For that reason, I’m going to have to give a very general response here, starting with asking a bunch of questions. These are questions that anyone should ask in connection with paying off a mortgage as part of an overall retirement strategy.

How much of your retirement savings will you have left after paying your mortgage off? My general feeling is that if paying off your mortgage will leave you with little or no retirement savings, then you shouldn’t pay off the mortgage. You’ll need those funds to help pay for living expenses.

On the other hand, if paying off your mortgage will use up only a small percentage of your retirement savings, that will probably be a good strategy. Though the money used to pay off the mortgage will no longer be available to generate an income, it will remove a major expense, and that provides a similar benefit.

How much of your expected monthly retirement income does the monthly mortgage payment take up? If your monthly mortgage payment is eating up a lot of your monthly retirement income, it might make a lot of sense to pay the mortgage off. It should improve your cash flow, so that you will need less retirement income.

But if the monthly mortgage payment isn’t killing your budget, it might work to your advantage to leave the money in the retirement accounts where it will continue to earn income.

Another consideration is how much of your monthly house payment actually goes to the mortgage payment? For example, for people who purchased their homes decades ago, the principal and interest portion of their house payment may be only a few hundred dollars a month. But the real expense is high property taxes. It’s always important to realize that property taxes and homeowners insurance don’t go away when you pay off your mortgage.

If it turns out that property taxes are the biggest chunk of your house payment, the question may not be whether or not to pay off your mortgage, but whether or not you should consider downsizing to a less expensive residence.

What interest rate are you paying on your mortgage? If the interest rate you’re paying on your mortgage is 3.something percent on a fixed rate loan, you have locked in one of the lowest interest rates in history! If your monthly mortgage payments aren’t hurting your budget much, you might not want to be so quick to pay it off.

This is even more true if you have been averaging a higher rate of return on a retirement savings. For example, if your mortgage is 3.5%, but you’ve averaged 7% on your retirement portfolio over the past few years, paying off your mortgage could work against you.

On the other hand, if you’re paying 6% on your mortgage, and you have only been averaging 4% on your retirement savings over the past few years, it will make sense to pay off the mortgage. In that way, you’ll be effectively locking in a 6% return on the money that is used to pay off the mortgage.

How many more years do you have to go on your mortgage? If you only have a few years to go on your mortgage – certainly less than 10 – you may want to keep the money in your retirement plans, and use non-retirement resources to pay off the mortgage. The reason I suggest this is because a loan that has only a few years to go on it is a temporary debt. But the money that you will pull out of retirement savings to pay it off will be gone permanently. That’s an unequal exchange.

But if you have another 15 to 20 years to go on your mortgage, you may want to pay it off as soon as possible. A remaining term that long could mean that you will be making a mortgage payment for the rest of your life.

One other consideration: don’t forget about income taxes! If you are going to draw money from retirement savings in order to pay off your mortgage, you’ll have to pay ordinary income tax on the withdrawal. You will have to factor those taxes into the equation.

For example, if you owe $100,000 on your mortgage, and you have an effective federal and state marginal tax rate of 33%, you will have to withdraw $150,000 in order to pay off the mortgage and the taxes due on the withdrawal.

This is one of the major reasons why paying off a mortgage out of retirement savings is a move that you must be especially careful about. It doesn’t always make financial sense.

Move Retirement Money into a Roth IRA

This question is especially difficult to answer without knowing what the reader’s income tax bracket is. If you move money from a 401(k) and a traditional IRA to a Roth IRA, you will have to pay ordinary income tax on the conversion. But whether or not they are going to convert to a Roth IRA will really depend on income taxes.

Using the example above, of a combined federal and state marginal tax rate of 33%, the couple will lose one third of the transferred balance by moving the money to a Roth IRA. Yes, they will be gaining tax-free income going forward, but not before their savings take a big hit on the transfer.

It’s not just about paying the tax either. Losing that much of your savings to income taxes upfront means you will also be earning less on your savings than you are right now. For example, a 10% return on $300,000 will produce a $30,000 investment income per year. A 10% return on $200,000 – after paying 33% in income taxes on the conversion – reduces annual income to $20,000.

A better strategy may be to wait until after the couple actually retire, when their tax bracket is lower. At a marginal tax rate of say 15%, the conversion will make more sense.

A better strategy might be to leave their retirement savings where they are now, but begin making Roth contributions based on their current earned income. No indication is given as to how much longer they plan to work, but they can make contributions as long as they do.

They may even want to supplement those contributions with small amounts of conversions from their existing retirement plans. That will keep the tax bite on the conversions to a minimum.

I know I kind of went all over the place with these answers, but the questions were general, and open up a lot of possibilities. Hopefully, I’ve covered most of those possibilities for anyone who may be in a similar situation.

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